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Should You Discuss After-Tax Contributions to Retirement Plans With Your Financial Advisor?

Taxes affect your hard-earned money, but you cannot avoid them. However, you can plan for taxes so that you eventually do not end up paying more to the government than necessary. By understanding how different tax rules and strategies can help reduce your tax bill, you have a greater chance of saving more money for retirement. Retirement plans comprise pre-tax or after-tax contributions or a combination of both. Each type of contribution has a significant impact on your retirement income. Hence, it is beneficial to consult a financial advisor to understand which contribution suits your financial situation the best. Retirement accounts, in particular, with after-tax contributions have become increasingly popular because of their tax-saving benefits.

Here is what you should know about after-tax contributions:

What are after-tax contributions?

To encourage people to save for their retirement, the government offers several tax-advantaged retirement plans. The most popular ones are a 401(k) and an IRA (Individual Retirement Account). A 401(k) is an employer-sponsored plan, whereas an IRA is offered by an authorized financial institution like a bank. Both retirement plans comprise different kinds of contributions.

The traditional 401(k) and IRA allow you to deposit only pre-tax money. However, the Roth versions of both these retirement accounts permit you to make after-tax contributions. After-tax contributions are also known as non-concessional contributions and are typically defined as deductions made from your salary after your income tax is cut for a specific year. Essentially, retirement plans with after-tax contributions comprise dollars that have already been taxed. Hence, these contributions do not reduce your income, and you cannot deduct them on your annual tax return. This is in contrast to pre-tax contributions that are deducted from your salary before your income tax is charged. Thus, reducing your taxable income.

In the case of Roth accounts, since you have made after-tax contributions, you owe no further taxes on the account balance even at the time of withdrawal. That said, in the case of traditional retirement plans with pre-tax dollars, the IRS (Internal Revenue Service) gets its due when you withdraw your funds.

What are the contribution limits of after-tax and pre-tax retirement accounts?

Both pre-and post-tax retirement accounts have a specific contribution limit.

  • In case of a Roth 401(k) (after-tax) and traditional 401(k) (pre-tax) account, the annual contribution limit for 2020 and 2021 is $19,500. People over the age of 50 can contribute $6,500 more.
  • In the case of a Roth IRA (after-tax) and a traditional IRA (pre-tax), the annual contribution limit is $6,000 for 2020 and 2021. People above the age of 50 can deposit additional funds up to $1,000.

You can have more than one pre-and post-tax retirement accounts. However, the overall contribution limit for all accounts will remain the same, as specified above.

Besides some employers also allow you to make after-tax transfers in a traditional 401(k) plan. So, if you hit the annual pre-tax 401(k) contribution limit, you can deposit an additional after-tax sum up to $38,500 in your traditional 401(k) account. Earnings on after-tax contributions are treated as pre-tax by the IRS and can grow tax-deferred until withdrawn. You can also roll over your after-tax 401(k) portion into your Roth IRA for greater benefits. Besides, in some cases, following a special provision of the tax code, you can take out the after-tax part of your traditional 401(k) plan as soon as you retire.

That said, the IRS changes the contribution limits and other rules for these accounts every year. Hence, it is advisable to consult a financial advisor regarding your after-tax contributions so that you make the most of these retirement plans.

What are the pros and cons of after-tax contributions?

Before deciding on the type of contribution to opt for, it is advisable to engage with a financial advisor to better understand the pros and cons of after-tax contributions, and to know if these contributions suit your financial needs and retirement goals.

Pros of after-tax contributions

The main advantage of after-tax contributions is that your retirement funds are not subject to any further taxes. This provides your money a better opportunity for tax-deferred growth in the long-run. Thus, post-tax deposits make the most sense for you if you expect yourself to fall in a higher tax bracket during the retirement years of your life. This could be because of an increase in your future retirement income or a hike in the future tax rates.

Another benefit of post-tax contribution is that you can withdraw your funds at any time without the IRS levying any penalties if you meet certain criteria. The conditions when your withdrawals are tax-free include:

  • You only take your original contributions, irrespective of your age.
  • You are 59.5 or older and have held your Roth IRA account for five years or more since the first contribution.
  • You have held your Roth IRA account for more than five years, but you are not older than 59.5 and are taking the distribution because you are disabled/ or you are a beneficiary inheriting a Roth account/ or you qualify for an exception as described by the IRS.

However, in the case of pre-tax or traditional accounts, if you take the distributions before the authorized age of 59.5, the IRS will charge a penalty of 10%, in addition to the income tax liability on withdrawals. Besides, after-tax contributions also help you mitigate your retirement tax burden in another way. If you make these contributions, then at the time when you leave your company or take official retirement, you will have an option to roll over the tax-deferred growth into a traditional IRA, and rollover your after-tax 401(k) contributions into a Roth IRA.

Cons of after-tax contributions

One of the major drawbacks of after-tax contributions is that your paycheck gets smaller with every contribution you make to your Roth 401(k) or IRA. Alternatively, pre-tax contributions reduce your taxable income for the year, and ultimately your tax liability for the year in which you make the contribution.

When do after-tax contributions make sense?

After-tax contributions are suitable in the following conditions:

  • If you have high earnings: After-tax contributions make perfect sense when you have significantly high earnings, but you have maxed out your pre-tax retirement plan contributions. In this situation, you can save more by making additional after-tax deposits in a 401(k) plan or any other defined contribution plan.

  • If you expect higher retirement income: After-tax deposits are good for you if you are certain that your retirement income will be significantly high, and you might fall into a higher tax bracket during the latter part of your life. By making after-tax contributions, you will make your withdrawals tax-free during retirement. Additionally, if you expect the future tax brackets to be more compact or the rate to shoot up higher, you can consider after-tax contributions in a retirement plan of your choice.

  • If you want to maintain an emergency corpus: After-tax contributions made to retirement accounts can be withdrawn without any tax charges. This allows you easy and immediate access to funds if ever needed to cover any unplanned or emergent expenses. However, it is advisable to be mindful of the various tax-free withdrawal eligibility conditions. It may also be advised to seek help from a professional financial advisor to better understand if after-tax contributions are suitable for you.

To sum it up

There are multiple retirement plans, each with different rules regarding contributions, withdrawals, and taxation. Moreover, the tax landscape changes frequently, which makes retirement planning a bit complex without the sound advice of a professional financial advisor. So, when it comes to retirement planning, consider consulting a professional financial advisor to understand which type of contributions or retirement plans suit your financial goals and situation.

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